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Converting to a Roth IRA is treated as if it were a distribution from your traditional IRA. Therefore, in the tax year you convert, you’ll owe taxes at your regular income tax rate on your investment earnings and on any deductible contributions you made to your traditional IRA. Here are the details.
You’ll also owe taxes on any amounts in your traditional IRA that you rolled over from an employer-sponsored retirement plan, such as a 401(k) or 403(b).
However, you won’t owe income taxes on any nondeductible contributions you made to your traditional IRA. And even if you’re under age 59½, the 10% federal early withdrawal penalty is waived on the amount converted.
Another tax consideration: Because the phantom income from a Roth IRA conversion may increase your annual tax bill, you may need to increase your income-tax-withholding or estimated tax payments. If you don’t, you risk a penalty for underpayment of taxes.
For more information, consult with a tax advisor or refer to IRS Publication 505, Tax Withholding and Estimated Taxes, www.irs.gov.
To benefit from converting, you should generally pay the conversion taxes from your current earnings or with money from a taxable account outside your IRA.
If you don’t have this extra money and you have to dip into your IRA to pay the taxes, you’ll be left with less money to compound tax free in your Roth IRA. Plus, if you’re under age 59½, you’ll generally have to pay a 10% early withdrawal penalty on the taxable portion of your IRA withdrawal. Depleting your IRA and paying these extra taxes will generally outweigh the benefit of conversion.
To lower the annual taxable income from the conversion, you have the option of converting only a portion of your traditional IRA to a Roth IRA. Or you can make partial conversions over several years. And if you have more than one traditional IRA, you can convert only one.
However, if you have both a deductible and nondeductible IRA or an IRA that contains both types of contributions, the conversion amounts are treated as coming proportionately from every IRA you own. In other words, all your traditional IRAs are treated as one account to calculate the taxable portion of the amount converted.
Consequently, the conversion is considered a mix of both nontaxable, nondeductible contributions, and taxable, deductible contributions and earnings. That means you can’t try to lower your conversion tax bill by designating a distribution only as a return of nondeductible contributions.
Article is for educational purposes only and is not intended to provide specific tax or legal advice. For answers to tax questions, please see your tax professional. For legal questions, consult an attorney.
Representatives are registered, securities are sold, and investment advisory services offered through CUNA Brokerage Services, Inc. (CBSI), member FINRA/SIPC, a registered broker/dealer and investment advisor, 2000 Heritage Way, Waverly, Iowa 50677, toll-free (800) 369-2862. Nondeposit investment and insurance products are not federally insured, involve investment risk, may lose value and are not obligations of or guaranteed by the financial institution. CBSI is under contract with the financial institution, through the financial services program, to make securities available to members. CUNA Brokerage Services, Inc., is a registered broker/dealer in all fifty states of the United States of America. The Representative may also be a credit union employee that accepts deposits on behalf of the financial institution.
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